Corporate: Duties of directors in the wake of a liquidity crisis
From a purely financial perspective, financial advisors and audit firms generally agree that businesses should take the following three measures in order to limit the impact of the COVID-19 crisis: (a) assess the financial situation and identify the risks, (b) take action with regard to immediate and potential short-term risks, and (c) improve resiliency and set up a mitigation plan.
In addition to economic aspects, directors should also think about their legal duties and potential liability (see our article Corporate: Mitigation of director's liability in the face of hardship).
In the framework of their duties and in the wake of the current liquidity crisis, directors must assess the company's financial situation and the potential legal solutions with regard to non-performance of the company's obligations and try to mitigate the financial impact of the crisis.
In brief, the duties of directors can be summarised as follows. Directors are obliged to (i) act as a reasonably prudent person (bon père de famille), (ii) manage the company's business in good faith (bonne foi) and with due care, in a competent, diligent, prudent and active manner, in the company's interest, and (iii) not do anything that does not fall within the company's corporate purpose.
In light of the COVID-19 crisis and the scope of their duties, directors of Luxembourg companies should act rapidly in order to protect the company's interests. For this purpose, it is of the utmost importance that the directors assess the company's liquidity position, its obligations and ability to meet them and identify potential financing opportunities to support the company throughout the crisis.
Diagnosis of the company's financial health
The directors shall adopt a pro-active stance to combat the effects of the crisis and potential liquidity shortages suffered by the company. In this respect, the first natural step is to review the company's cash flow position based on recent management accounts. This step may prove critical, as it will allow the directors, with the support of the company's financial and legal advisors, to identify any capital impairment or even potential solvency issues which could lead to bankruptcy.
However, this is only a preliminary review, as many additional items will need to be considered:
- Value impairment should be taken into account, as the crisis is likely to have a direct impact on the company's undertakings and therefore the value of its securities, generally booked as fixed as-sets, which could lead to a significant drop in the company's net asset value. In this respect, the directors may have to resort to the alarm bell procedure.
- Aside from figures, it is of the utmost importance that directors identify any off balance sheet commitments (such as guarantees granted to affiliated parties or any other type of security inter-est, such as a pledge of securities) and gather information about the ability of affiliates to meet their obligations, lest the company be held liable under the guarantee or security arrangement. In the context of a corporate group, cross-default is a plausible risk, and the diagnosis of the company's financial situation and a complete risk exposure analysis cannot be performed with a simple stand-alone review.
- The directors should consider the potential enforcement of any pledge the company may benefit from should this prove necessary to secure the company's financial position.
Once the position of the company has been diagnosed, an in-depth review should be performed if the directors identify certain obligations that may not be satisfied. In this respect, they shall further assess whether
(i) agreements may be terminated,
(ii) breaches can be cured, and
(iii) force majeure or agreed material adverse change clauses triggered and enforced.
Although the term may seem extreme, this review by the directors and the company's financial and legal advisors is akin to a due diligence process.
Furthermore, with respect to pending litigation or disputes, there is a heightened risk of parties becoming insolvent as a result of the current crisis. With that in mind, directors may wish to consider alternative means of protecting the company's interests. Likewise, uncertainty in business circles may encourage recourse to settlement and the abandonment of litigation should the directors conclude that the chances of a ruling against the company are quite high and that settling would be less costly.
Finally, directors must assess whether the company's current obligations meet the corporate interest test. The corporate interest shall always serve as the compass for any decision by directors of whether the performance or the suspension/termination of obligations would be opportune for the company and allow it to meet its objectives efficiently.
Mitigation of the spread: government subsidies and commercial bank initiatives
One of the first measures taken by the Luxembourg government following the lockdown was the creation of a so-called stabilisation package, i.e. a set of approximately 20 measures aimed at providing finan-cial relief to businesses of all sizes, usually those with real economic activity (pure holding companies are generally excluded from the scope of these measures), through direct financial support, the provision of guarantees, tax relief (e.g. the cancellation of advances on certain taxes or the extension of deadlines), and employment and social security measures (in particular short-time work) (see our State Aid Tracker).
The availability of the various types of state aid will depend on their nature. While certain types of aid will be granted with no prior conditions, other types of aid will only be available as an alternative or cannot be combined with aid covering the same type of cost if the combination would result in certain thresholds being exceeded.
It is therefore of the utmost importance that the directors assess the state aid their company could benefit from and take action in order to apply for the appropriate forms of assistance. Any failure to do so by the directors of a company facing financial difficulties due to the COVID-19 crisis will qualify as gross misconduct on their part, which could lead to consequences in terms of director's liability.
In addition to state aid, commercial banks have taken initiatives to support the economy and provide some breathing room to companies facing financial difficulties. In this respect, certain Luxembourg commercial banks may grant a suspension of loan repayments for a period of up to six months (to be negotiated) at the express request of the borrower. In this respect, it is recommended that directors contact the company's bank(s) to request a suspension of loan repayments, if necessary.
If these measures are insufficient to allow the company to meet its obligations, the directors should consider requesting the company's shareholders to provide additional funding, either through equity, i.e. by way of a share capital increase or a contribution to a special reserve, the so-called account 115 of the Luxembourg standard chart of accounts (an apport en capitaux propres non rémunéré par des titres), or debt, i.e. the grant of a direct loan or the subscription to debt instruments issued by the company. However, it should be recalled that in general shareholders do not have a statutory obligation to either (i) contribute more than they initially contributed at incorporation or (ii) grant additional financing to the company. In this respect, the directors should also review any shareholder agreements in order to determine whether they contain contractual obligations on the part of the shareholders to provide additional financial support to the company (in any form whatsoever) should the company be in financial distress or face bankruptcy and whether the company's current financial situation justifies reliance on such obligations.
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